Credit cards are everywhere in our society, yet they can be a touchy subject. And although many people use credit cards, few people really know how credit cards work. Credit cards are convenient and easy and come with several perks, and they have ruined people’s finances in the blink of an eye. They can be a superhighway to high interest consumer debt that is near impossible to get out of. Some choose to ignore the dangers of credit cards and use them blissfully until their debt suddenly cripples them. Others rightly recognize the dangers and refuse to even open a credit card offer. If I had to choose one or the other, without a doubt I would forgo credit cards completely. However, these are not the only two options. If used correctly, credit cards can be a valuable part of your personal finance toolkit.
How Credit Cards Work
Before we dive into the right way to use credit cards and the pros and cons of credit cards, lets cover the basics. Knowing how credit cards work is important to knowing how to use them.
Credit Cards are Revolving Debt
Credit cards are a type of revolving debt. Most credit card accounts have a credit limit. As long as you keep your balance under your credit limit, you can continually take on new debt by making purchases. You also consistently pay down that debt with your monthly payments. Unlike amortized debt (such as mortgages and car loans) where your payment plan consistently reduces the size of the debt, revolving debt allows your balance to continue to grow, often without you realizing.
Credit Cards are Unsecured Debt
Since there is no collateral tied to credit card debt, they are a form of unsecured debt. This means that if you fail to make your payments, the credit card company can not immediately seize property of yours that is tied to the debt. In a home mortgage, which is secured debt, the bank could repossess your house if you failed to make a payment. If you think this sounds great, think again. In exchange for the extra risk, lenders charge a far higher interest rate on unsecured debt. This is why you can get a 3-4% interest rate on your home loan, while a typical credit card interest rate is closer to 20%.
Don’t fall under the impression that because credit cards are unsecured debt, you can default on your credit card balances without consequences. Although the credit card company can not immediately repossess property, defaulting on your credit card will seriously impact your credit score and will send your bill to collections. If you continue to neglect your debt, creditors can bring a suit against you and potentially have your wages garnished.
What Does it Mean to Carry a Balance?
Although you are required to make a payment on your balance every month, you are not required to pay off your entire balance. When you pay less than your balance, the remainder is called a ‘carried balance’. Any new charges that you incur in the next month get added to this carried balance.
When Do You Owe Interest?
One common myth about credit cards is that you automatically pay interest on any and all purchases. This is NOT true! As long as you never carry a balance, you will never owe any interest! In other words, if you pay your balance in full each month, you will never owe any interest. Once you start carrying a balance, you start owing a 20% (annually) interest rate on that balance. Once you pay off your balance in full, the interest charges will stop.
One other way to avoid interest is with special offers where interest is waived for a specified time period. Be careful with these, however. First, using this offers develops the bad habit of carrying a balance. Second, the fine print of the deals often gets tricky. For example, many of these offers stipulate that the 0% offer is only valid if you pay off your balance in full within the time period. Otherwise you get nabbed with current interest and all the back interest from the promo period. I recommend staying away from these offers.
How People Get Buried in Credit Card Debt
I don’t think anyone opens a credit card account with the intention of burying themselves in debt. And yet it happens. There’s a reason so many ads on TV advertise credit card debt relief. It’s a serious pain point. According to NerdWallet, the average credit card debt balance was over $15,000 last year. $15,000 of credit card debt is extremely hard to pay off! That can easily be a quarter to half of your income. Furthermore, $15,000 means the first several hundred dollars of your monthly payment is just going towards interest! And remember, $15,000 is just average- there are people with far higher balances. So just how do people dig themselves this deep?
Spending With a Credit Card is Easy
Swiping a credit card is so easy you barely even think about it. Psychologically, paying with cold cash makes you much more aware of the amount of money you are spending. You physically have to get the money out of your wallet and hand it over to a cashier. With a credit card, you can easily swipe multiple times on a single shopping trip and barely register the hundreds (thousands!?) of dollars you’ve just spent.
A Credit Card Allows You To Spend Money You Don’t Have
It should go without saying, but a credit card allows you to go into debt. Or in other words, spend money that you don’t have. When you’re paying with cash, check, or debit card, your spending must come to an end once your money dries up. Not so with a credit card. Your only limit is the limit that the credit card company gives you. This limit is based primarily on your credit report and a little bit on your annual limit, and not at all based on your cash on hand.
Our Short Term Consumer Mentality Further Fuels Our Spending
When almost limitless spending capability and ease of spending is coupled with our consumer mentality, our spending goes wild. Advertisers bombard us 24/7. We crave to keep up with the Jones’ (or the Smiths or whoever). We feel like we always need the latest gadget. And somehow we’re convinced that every purchase will finally make us happy. We get hooked on spending, and suddenly we can spend as much as we want. Our short-term mentality makes this even worse. We focus so much on what we can buy now that we fail to think about how long we might be paying for our purchases.
The Terms of the Credit Card are Geared to Perpetuate Your Debt
The credit card company makes money on your debt, so they gear your credit card to keep you in ‘sustainable’ debt. And for them sustainable means getting you deep enough in debt that you can’t get out of debt, but not deep enough that you’ll default.
Carried Balance + Interest + New Charges = Perpetual Debt
They will set the limit as high as they deem sustainable. They set the minimum payment so low that it would take years to pay off your balance at just the minimum payment. And that’s if you stopped using your card for purchases. But since your credit card is a form of revolving debt, you’re always encouraged to add to that debt. Which brings us back to the carried balance concept. If you just make the minimum payment (due to short-term thinking, many people do), you’ll have a very large carried balance. Now add the high interest factor. Since you’re carrying a balance, you owe interest on that balance. So now, for the following month, your new balance now is a grand combination of last month’s large carried balance, the high interest on that balance, plus all the new purchases that you just had to make.
How to Use Credit Cards Wisely
So how do you avoid falling into the credit card debt trap? Although it takes discipline and resolve, it is possible to wisely manage a credit card.
NEVER Carry a Balance
This is the single most important rule of using a credit card. Carrying a balance under any circumstances should be avoided at all costs. For one, the ~20% interest rate is so outrageous it borders on highway robbery. But far worse, carrying a balance even once opens you up to the mentality that carrying a balance is OK. Credit card debt is the financial industry’s heroin and you never know when you’ll get you hooked for life.
Keep Your Spending Within Your Budget
To not carry a balance, you need to be able to pay your bill in full. Which means that every purchase you make has to be within your budget. Some people like to describe this as using your credit card as a debit card. There are several ways to do this, but one easy way is to record every credit card purchase in your check registry, deducting the purchase from your bank balance as if it has already left the bank. Use self-discipline to not let your registry balance go below 0.
Another way is to set up a budget with an online tool such as Mint. Many online budgeting tools will sync with your credit card account, classify each purchase, and immediately deduct each purchase from the various budgeting categories that you’ve set up. When you’ve maxed out a budgeting category for the month, stop spending in that category. As long as your budget is in line with your actual income, you should never have any problems paying your credit card balance in full. Again, this requires some self-discipline and initiative to set up the budget and then adhere to it.
A big part of using a credit card wisely is knowing how much financial self-discipline you have. I do NOT mean this as a challenge or a put down! You are not a worse person by recognizing that you are vulnerable to credit cards debt. If you don’t trust yourself taking a credit card shopping, then don’t! Only carry cash with you. But perhaps you can use your credit card strictly for monthly bills. You’re not going to ask your electric company to double your bill just because you’re paying with a credit card. Perhaps you can also use your credit card for gas. You’re likely not going to drive more miles just because you filled up with a credit card. A credit card also allows you to pay at the pump, avoiding the temptations of the convenience store. Figure out what works for you and go with it.
Automate Your Payments
Few things will make you want to kick yourself more than having to pay interest and late fees just because you forgot to pay the bill. To my knowledge, all credit card providers allow you to set up automatic payments. Use this feature! Set up your account to be payed in full each month. Not only are you avoiding late fees, you’re also saving on stamps, checks and time. While you’re at it, put all your other regular bills on autopay.
Stick With No-Fee Cards
Some credit cards come with annual fees, some don’t. Sometimes the annual fee buys some amazing perks, but a lot of the time, cards with fees are no better (or worse) than fee-free cards. For the average consumer, fee-free cards are the best bet. If you are a frequent flyer, or a frequent hotel lodger, or a mega-grocery shopper, perhaps paying a fee might make sense. Just make sure whatever the fee is buying is worth the cost.
So Why Even Bother With Credit Cards?
With the risk of burying yourself in credit card debt and super high interest, why even give credit cards a look? What benefits are worth risking a lifetime of debt? As I said before, if you are vulnerable to credit card debt, you’re better staying away. But if you are able to use credit cards responsibly, the benefits are many.
Credit Card Rewards
For many, myself included, rewards are credit cards’ biggest draw. After all, who wouldn’t want to earn 1-3% back on purchases they were making anyway. For the sake of simplicity, I prefer cards that don’t have rotating categories. For the sake of flexibility, I prefer cards that pay you back in straight cash. But find the card that works well for you. My favorite two cards are the American Express Blue Cash Everyday and the Citi Double Cash Card. I earn roughly $400/year in credit card points- not exactly chicken change.
Credit Card Perks
In addition to the rewards, credit cards often come with a range of lesser known perks. Some cards offer purchase protection on anything charged on the card. Often cards include complimentary car rental insurance. If you travel you might appreciate the cards that you can use internationally with no currency exchange fees. For whatever reason, card companies don’t really advertise the card perks, so you might be surprised at what different cards offer.
Credit Cards Can Effectively Earn You Interest
Yes, I know, credit cards are designed to cost you in interest. So how in the world do they earn you interest? Of course this only works when you’re paying your balance in full every month. Even when you don’t carry a balance, you don’t actually pay for your credit card expenses until your bill is due, which is almost a month after the bill is issued. Furthermore, since this balance includes all the charges made over the previous month, there will be some charges that you won’t actually be paying for almost 2 months. This all means cash stays in your bank account longer, which means you earn more interest. Of course, right now, your bank account likely isn’t topping 1% interest, but its better than nothing.
Credit Cards Offer Better Fraud Protection than Cash or Debit
This may seem counter-intuitive. Many people avoid credit cards specifically because they are worried about people stealing their information and racking up debt in their name. One thing most credit card companies are very good about, however, is sticking to their $0 fraud liability pledges. A single call is typically enough to have fraudulent charges removed from your account and a new card issued. A debit card, on the other hand, often comes with $50 fraud liability. And with cash, you are liable for as much as is in your wallet when you lose it or have it pick-pocketed
Using a Credit Card Maintains Your Credit Score
Regularly using a credit card is the easiest way to establish good credit, which may be far more important than you assume. Lenders use your credit score to determine how risky of a borrower you are. This determines how much they will loan, and at what interest rate. A good credit score makes future loans more available and cheaper.
Even if you have no intention of borrowing money, your credit score is still important. They are used by far more than just lenders. Insurance companies view people with good credit scores as safer clients, and therefore offer lower rates to customers with good credit. Landlords also check credit history to decide whether to rent to prospective tenants, and even to decide upon rents. Even some potential employers check their applicant’s credit scores when making hiring decisions. Regularly using a card and consistently paying it off establishes a good credit history and score.
The Credit Card Verdict- A Mixed Bag
So are credit cards dangerous? Absolutely. Does that mean no one should use them? I don’t think so. If play your cards right (pun?), you won’t pay a dime in interest or fees, you’ll rack up rewards, you’ll strengthen your credit score and protect yourself from fraud and loss. However, if you do slip into a credit card’s debt trap, you can quickly drown in payments and interest that will suck the life out of your finances. And yes, it is every bit as bleak and depressing as it sounds.